Enter Values
%
10-year Treasury yield or similar
Market sensitivity (1.0 = market average)
%
Historical S&P 500 average: ~10%
Quick Reference
- Beta = 1: Moves with the market
- Beta > 1: More volatile than market
- Beta < 1: Less volatile than market
- Beta < 0: Moves opposite to market
Expected Return
Market Risk Premium (Rm - Rf)
Expected Return E(Ri)
10.00%
Risk Premium for Asset
Formula Breakdown
E(Ri) = Rf + Beta x (Rm - Rf)
= 4.50% + 1.00 x (10.00% - 4.50%)
= 4.50% + 1.00 x 5.50%
= 4.50% + 5.50%
= 10.00%
Interpretation
With a beta of 1.00, this investment is expected to match the market return. The expected return of 10.00% equals the market return of 10.00%.
Understanding Your Result
| Below Risk-Free | Beta < 0 or Rm < Rf | |
| Risk-Free Equivalent | Beta equals zero | |
| Below Market | 0 < Beta < 1 | |
| Market Average | Beta equals 1 | |
| Above Market | Beta > 1 |
Understanding the Capital Asset Pricing Model
What is CAPM?
The Capital Asset Pricing Model (CAPM), developed by William Sharpe (1964) and John Lintner (1965), is a foundational model in finance that describes the relationship between systematic risk and expected return. It won Sharpe the Nobel Prize in Economics in 1990.
CAPM answers a fundamental question: "What return should I expect from an investment given its systematic risk?"
Key Insight: According to CAPM, only systematic risk (measured by beta) is rewarded with higher expected returns. Unsystematic risk (company-specific risk) can be diversified away and earns no additional return.
Understanding the Inputs
- Risk-Free Rate (Rf): The return on a theoretically riskless investment, typically proxied by government bond yields. The 10-year Treasury yield is commonly used.
- Beta: Measures how much an asset's returns move with the market. A beta of 1.5 means the asset tends to move 1.5% for every 1% market move.
- Market Return (Rm): The expected return of the overall market. Historically, the S&P 500 has returned approximately 10% annually.
- Market Risk Premium (Rm - Rf): The extra return investors expect for bearing market risk. Historically averages 5-7%.
Practical Applications
CAPM is widely used in corporate finance and investment analysis:
- Cost of Equity: Companies use CAPM to estimate their cost of equity capital for DCF valuations and capital budgeting
- Hurdle Rates: Setting minimum required returns for investment projects based on their systematic risk
- Portfolio Construction: Evaluating whether an investment offers sufficient expected return for its risk
- Performance Evaluation: Comparing actual returns to CAPM-predicted returns (the basis for Jensen's Alpha)
Limitations of CAPM
Important: CAPM is a simplified model with assumptions that don't always hold in practice.
- Single-factor model: Only considers market risk; ignores size, value, momentum, and other factors
- Beta instability: Historical beta may not predict future beta reliably
- Market efficiency: Assumes all investors have access to the same information
- Static model: Doesn't account for changing risk over time
- Ignores taxes and costs: Real-world frictions affect actual returns
Consider complementing CAPM with multi-factor models (Fama-French, Carhart) for more robust analysis.
Frequently Asked Questions
The CAPM formula is: Expected Return = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate). For example, with a 4.5% risk-free rate, beta of 1.2, and 10% expected market return, the expected return is 4.5% + 1.2 x (10% - 4.5%) = 11.1%.
A "good" expected return depends on your risk tolerance and the current risk-free rate. Generally, returns above the market return (around 10% historically for US stocks) indicate higher systematic risk. Compare expected returns to the market benchmark and your required hurdle rate rather than using absolute thresholds.
Stock betas are available on financial websites like Yahoo Finance, Bloomberg, or Google Finance. Beta measures a stock's volatility relative to the market: beta = 1 means market-average volatility, beta > 1 means more volatile, and beta < 1 means less volatile. You can also calculate beta using regression analysis of historical returns.
The risk-free rate is the return on a theoretically riskless investment, typically proxied by government securities like US Treasury bonds. The 10-year Treasury yield is commonly used for long-term analysis. As of 2024-2025, it's around 4-5%. In some countries like Japan or the Eurozone, risk-free rates have been negative in recent years.
The market risk premium (MRP) is the expected market return minus the risk-free rate. It represents the extra return investors expect for taking on stock market risk instead of holding risk-free assets. Historically, it has averaged 5-7% for US stocks, though estimates vary. It's a key input for calculating cost of equity.
CAPM has several limitations: it's a single-factor model that ignores size, value, and momentum effects; beta is backward-looking and may not predict future volatility; it assumes markets are efficient; and it ignores taxes, transaction costs, and liquidity constraints. Consider using multi-factor models (Fama-French, APT) for more comprehensive analysis.
CAPM is widely used in corporate finance and investment analysis. Companies use it to calculate their cost of equity for DCF valuations and weighted average cost of capital (WACC). It's also used to set hurdle rates for capital budgeting decisions, evaluate portfolio performance (via Jensen's Alpha), and compare investments on a risk-adjusted basis.
Disclaimer
This calculator is for educational and informational purposes only. CAPM provides a theoretical expected return based on simplified assumptions that may not hold in practice. Actual returns may differ significantly. Beta estimates are based on historical data and may not predict future volatility. Always consult with a qualified financial advisor before making investment decisions.
